Written by Kyle J Christensen, CFP, Aug. 14, 2020
The truth is, money is debt. Dollars are the only “legal tender” in the United States. In other words, dollars, which are a debt obligation (a promissory note) of the US government (printed by The Federal Reserve), is the only money in the United States. If a person wants to avoid debt entirely, they are also saying they want to avoid having money, which is debt. Now, I am not suggesting that people shouldn’t pay off their liabilities. They should, especially if they have consumer debt.
There are two types of debt, Consumer Debt and Business/Investment Debt. Consumer debt should be avoided and paid off quickly. Consumer debt is usually the result of a lack of discipline and dedication to savings, and a lack of financial responsibility. Business and Investment debt, however, is called “leverage”. As a human being, as strong as you are, could you lift a car? The answer is yes and no. No, you can’t do it by yourself, without tools and equipment. And yes, if you do it with the right equipment and tools. What do the right equipment and tools do? They provide leverage. Without leverage, you couldn’t do it. The same is true for significant wealth building. Without leverage, you cannot “lift” the amount of wealth and assets that are required to create financial freedom. No billionaire became such, without the use of leverage of capital and work from others.
With this article I am not suggesting that you don’t pay off your debt. I am suggesting that how you pay it off matters.
There are at least three major factors, financially, when analyzing debt. First is the interest. Interest that you pay on debt is money that is lost, that you will never get back. Most people focus almost entirely on this aspect of a debt, and as such, want to pay it off as quickly as possible. If that’s all I knew about it, I would want to pay it off as quickly as possible too. The second aspect of a debt is the monthly payment and length of time to repay. For most people, they also view this as a huge drag on their money and justifiably want to get rid of it. Plus people don’t like owing other people/businesses/banks. So, emotionally, people want to eliminate the monthly payment. The third aspect of debt, that virtually no one (besides extremely successful businesses and investors) even acknowledges is the Cost of Money or Opportunity Cost. It’s this third aspect that I want to address in this letter.
Do banks want us to give them our money sooner or do they want us to give it to them later? And why? No one would disagree that banks want us to give them our money sooner, not later. They even incentivize it. Consider mortgages. Do banks incentivize us to do 15-yr loans over 30-yr loans? Yes. Is the most important thing to the bank the amount of interest they are going to collect? It can’t be, because banks encourage us to 1) do 15-yr loans by giving a better interest rate for them, and 2) they package and sell the mortgage loans almost immediately after they set them up. If they cared most about the interest they were going to collect, they would incentivize 30-yr loans and they would keep them to maturity. That’s not what they do though! Why? Because they understand the third aspect that I am talking about, which is in fact, the most important one when it comes to wealth building.
On the surface, if we only look at aspect #1 (the interest) it’s easy to tell that a 15-yr loan costs much less than a 30-yr loan. For example, let’s say we have a $500,000 mortgage. The 15yr loan is at 3% and the 30-yr loan is at 3.60%. If you pay each one to the maturity of their repayment schedule, you would pay $621,523.80 for the 15-yr loan versus $818,362.80 for the 30-yr loan. Based on this alone, it’s obvious that doing the 15-yr loan is the better one (lower cost option). Right? Actually it’s not, because we are ignoring the third and most important aspect. Again, why would a bank incentivize us to give them less money? Or are they?
First off, are opportunity costs real or are they made up? Here’s an easy way to find out. If you had $10,000 and had plans to use that money to do something, and then suddenly you lost it somewhere, would you say you only lost the $10,000 and nothing more? Or, would you say that you also lost what you were going to use the money for? If you accidentally paid more in taxes than you needed to, and you never got that money back, would you say you only lost the dollar amount of those taxes? If you don’t think like banks and highly financially successful people you might say yes. However, banks and highly successful people would say otherwise. That’s why Warren Buffet’s number one rule for investing is “Don’t lose money”.
Opportunity costs are in fact real. Wealth is neither created nor destroyed. It is only transferred, from one person to another, or from one business to another. If by paying a mortgage off early, the bank gains more wealth, which I will prove shortly, then that also means by paying off a mortgage early you lose the most wealth (wealth is not created or destroyed, it is only transferred). And unless banks don’t know what they are doing, they understand that by you paying the loan off quicker, they make more money even at a lower interest rate.
Here’s how opportunity cost is calculated. If you take the example of the two mortgages, the 15-yr and the 30-yr, we need to first measure the same time frame. Let’s go out 30 years for each scenario. Now, we have to choose an opportunity cost rate (aka the Cost of Money) for the test. Generally Cost of Money is determined by whatever the next best use of the money is for a person. In other words, if the money weren’t lost, what else could they have done with it? Let’s use a cost of money of 8% for the scenario. So, as an example, if $1 is lost on day one, year one, the true cost of losing that dollar is actually $10.06 after 30 years ($1 @ 8% for 30 years). It’s not just one dollar. This is also called “the time value of money”.
The 15-yr loan has two calculations we have to make. The first is for the first 15 years, when the mortgage payments are being made. The second calculation is for the next 15 years in which no more mortgage payments are being made. It is vital to remember that once money is lost, the opportunity costs continue to compound as long as you live. They don’t stop just because you stop adding money to it. Here we go. The monthly payment on the fifteen-year loan is $3,452.91. Again, without considering opportunity costs, the total paid on the 15-yr loan is $621,523.80. When we consider opportunity costs, the actual cost for the first 15-years is $1,195,262.37. This makes sense because this actually measures the wealth that the bank gets because you gave them the money sooner. It also demonstrates the additional wealth, beyond the interest, that you lose due to your own opportunity cost. We’re not done though, because we are measuring a 30-yr time frame, not a 15-yr time frame. The only difference for the second calculation is that we aren’t adding any more payments of $3,452.91. After the second period of 15-yrs, the cost of the 15-year mortgage ends up being $3,976,267. If you’ve ever wondered why most people will never become financially free, the fact that they don’t understand or consider opportunity costs is a major reason. Again, who ends up with this wealth? The bank.
Now let’s look at the 30-yr loan. Almost everyone would say that a 30-yr loan is more expensive than a 15-yr loan that has a lower interest and time-frame. Let’s see if that’s true. The monthly payment for the 30-yr loan is $2,273.23. The opportunity cost of the 30-yr mortgage after 15 years is $786,903.30, and after 30-yrs is $3,407,200.63. It is almost $570,000 less than the opportunity cost related to the 15-yr loan. That is not an insignificant difference!
As Robert Kiyosaki says over and over in his books, the difference between the wealthy and the poor is not where they invest. It’s what they know. Our job as advisors is to help them improve their knowledge, not sell them a product. Our job is to teach them wealth building principles, not just provide them with a product or a strategy. Products and strategies don’t create financial freedom. Knowledge does.